As Paul Newman’s character once said, “sometimes nothin’ can be a real cool hand.” This statement is apt in understanding the often ignored benefit of investment losses because tax loss harvesting can turn your situation into “a real cool hand.” In this article, we’ll look at the art and science of tax loss harvesting and how to leverage the practice to your benefit when the time is appropriate.

How Harvesting Works

In short, tax loss harvesting is the strategy of offsetting the tax burden on gains by realizing losses. To execute an investor must be willing to sell a security that has sunk below the amount originally paid for the shares. For the long-term thinker, this is counterintuitive; the “buy and hold” investor refuses to waiver in the face of losses that are almost sure to dissipate over a long enough horizon. However, there are two scenarios where a sale is wise even for the long-term player. First, if the security has minimal prospects it may be ripe for selling. This situation is present in companies that have outdated models or competitive pressures that are insurmountable. These problems are permanent. Second, a sale fits within a long-term plan when the investor replaces the liquidated security with a similar asset thereby avoiding any interruption to the preferred investing style and risk profile. However, this maneuver represents risks that we’ll see later.

After selling the underperforming security, the investor can use the loss against short-term or long-term taxes incurred on gains. Let’s look at an example. The investor purchases shares in company A which underperforms. The investor sells the stock thereby “realizing” a $4,000 loss. Then, the investor purchases shares of stock in company B which grows by $7,000. At a long-term capital gains tax rate of 15% the investor will pay $1,050 in taxes (15% x $7,000).

At this point, the power of loss harvesting comes into effect. The investor can use the previous $4,000 loss to erase the burden of $1,050 in taxes. By “netting” the investments the $4,000 loss is deducted from the $7,000 gain. Now the tax owed drops to $450 (($7,000 – $4,000) x 15% marginal tax). Remember that the amount saved changes depending on the investor’s marginal income tax bracket. The benefit of the strategy is most pronounced for investors in high tax brackets with substantial short-term gains. Harvesting long-term gains is less ideal given the already lower tax rate at this level.

Understanding Time-Sensitivity

Tax loss harvesting is often considered an end-of-the-year practice. This mindset is more a function of psychology than practicality. In truth, an investor can execute a tax loss move at any time. The more critical component is the duration of the loss and the gain; this has far reaching implications on the tax rate applied and ultimate savings. Many investors become more cognizant of their tax liability as the end of the year approaches and therefore engage in loss harvesting in the fourth quarter.

There are pitfalls to consider. First, some advocate against the strategy citing long-term problems. When the investor sells a losing security, then shortly after purchases a similar asset they’re picking up the security at a lower cost basis. In the long run, this amplifies the taxable gain because the investor acquired the shares when the price was depressed. The result: a larger spread between the cost and the value means more earnings which mean more taxes.

There is also a SEC “Wash Sale” rule to consider. This rule is designed to dissuaded investors from selling a security then immediately repurchasing the same or “substantially identical” asset within 30 days. The intention is to limit the transactions within the market executed solely for tax purposes. Following this rule is in the best interest of the investor for three reasons. First, it is required by law. Second, ignoring the restriction creates the added risk of sudden share price movements in the short-term thereby disrupting the strategy. Third, the law is vague regarding the definition of “substantially identical.” This opaque wording leaves a wide margin of error in ascertaining whether the new security is too similar. Allow for an ample timeline if you intend to leverage tax loss harvesting to stay within the regulations.

Harvesting as Part of a Broader Strategy

It is best to think of loss harvesting as an occasional outcome of a strategy which prioritizes for the fundamentals of the assets rather than timing and tax rates. Even the most steadfast “buy and hold” investor will need to cut losses and sell occasionally. Loss harvesting mollifies the impact of taking a loss but should not be the core of any strategy. Let harvesting happen as the situation presents itself, don’t create an environment for it.

Remain cognizant of your loss as they will accrue over a lifetime and will carry forward. If there are still losses remaining after all gains, have been offset you can deduct up to $3,000 from ordinary income. This further benefits your tax position. Loss harvesting requires that the investor starts by matching identical terms. For example, first offset long-term gains with long-term losses, then one can offset short-term and long-term gains and losses.

This strategy is ultimately a deferment of taxes rather than complete avoidance. When you repurchase the same or similar security you’re locking in a lower cost basis and therefore, future taxable gains. However, the concept is predicated on the time value of money; a dollar today holds greater value than a dollar in the future. With more time-horizon comes increased growth.

Investigate if a loss harvest is available if you have intentions to rebalance your portfolio or sell a poor performing stock.

After completing my MBA I spent a decade in the business world working for firms like Vanguard where I earned ground level experience. This practical background has served me well in my personal finance writing. My work is designed to distil the most important truths from financial research thereby empowering the reader with clear direction. My work includes Ebooks, articles, whitepapers and blog posts. In June of 2016 my Kindle book "The 90 Minute Personal Finance Plan For Life" reached the number one spot on Amazon under Personal Finance.